financial results, The Balanced Scorecard, Lean Thinking

The hard-nosed school of management lives by the sword of financial results - and sometimes perishes by that sword. In the end, true, all business management has the same purpose as managing investments. The final measure is the gap between what was invested in the business and what it is worth at a given moment in time. In the public service, the measure is different, but the principle is the same. Is the public getting progressively better value for the resources consumed?

But that begs the fundamental question. What enhances the worth of the business or the value of the service? In business, the obvious answer - a rising flow of profits - is only partial. The same profit stream attracts different valuations between different industries, and even between different companies in the same industry. The profits, in any event, spring from underlying activities. And it's the reputation created by the latter - including the strategic choice of industry - that substantially determines the valuation. In public sector organisations, too, it's the quality and scope of the services that enhances (or detracts from) value: not cost alone.

It follows that managers should concentrate on the underlying strengths and weaknesses of the organisation and use the financial reports as a check on the non-financial effectiveness. That's the essence of the 'balanced scorecard' approach, which treats financial outcomes as only one element in the measurement and targeting process. Typically, in business, half a balanced scorecard would relate directly to shareholders (including return on capital): 20% would be customer-related; 10% would be driven by internal processes; and the final fifth would score the organisation's ability to learn and improve.

CUSTOMER MEASURES
These are sophisticated calculations, although they can be applied to quite small and relatively simple organisations. Take the customer measures - which in the breakdown given above look somewhat underrated. In this real-life example, from a quite typical company, the customer category has six elements: (1) understanding, (2) innovative products, (3) cross-selling, (4) cost-effective channels, (5) minimal operating problems, and (6) responsive service. Rephrase the elements as questions, and you can see the demanding nature of the scorecard:

1. Do we really understand what the customers want?
2. Are we leading the market in innovation - in products and/or services and/or processes?
3. Is our operational effectiveness, as measured internally and by external customer rating, high and improving?
4. Are we fully using the existing customer base to build new business?
5. Is the distribution system continually reviewed and revised to take out cost and improve effectiveness?
6. Is everybody is the organisation trained to respond swiftly and helpfully to customer enquiries, orders and complaints?

Not only are these questions very demanding, but they force the company in strategic directions. The balanced scorecard, according to David P. Norton of Renaissance Solutions, 'puts strategy at the centre of the management system instead of finance.' But this desirable switch is no quick fix. Norton says that you have to allow up to two years for the process. Is it worth the effort? He cites the example of Mobil Oil, which in 1993 ranked seventh among the major oil companies in comparative profitability: within three years, it led the industry, and the share price had doubled.

You can't, of course, prove that the balanced scorecard caused these splendid results. That's the perennial problem with management nostrums. If success follows the use, the end seems to justify the means. But that's not scientific. There's no control group for comparison. You can't run history backwards, so you can't put the same company in the same circumstances through a different treatment. But in this case, there's a general principle which is very hard to deny.

This principle underpinned some 1989-90 research, conducted by the Nolan Norton Institute under KPMG's auspices, and entitled Measuring Performance in the Organisation of the Future; the study spawned the idea of balancing the measures. In The Balanced Scorecard (Harvard Business School Press) Norton, writing with Robert S. Kaplan, says that the research was motivated by a belief that reliance on short-term financial results hindered the abilities of organisations 'to create future economic value.' If management systems are based on financial measurement alone, you're tying the firm's destiny, not just to the short-term present, but to the past - for financial figures are lagging indicators.

Link managers' rewards to these indicators alone, and you're building short-termism into the system - WYPFIWYG: what you pay for is what you get. It could be argued that there is a future connection when judging management on past results, even though the previous year's profits are ancient history. A strong financial performance is the necessary foundation for future expansion. That's true. On the other hand, every manager knows that high profits can conceal latent deterioration. Taco Bell is an alarming example. It was an impressive corporate hero of 1993's best-selling book Re-engineering the Corporation, written by Michael Hammer and James Champy.

SHARE OF STOMACH
The fast food business rebuilt all its processes round a stirring mission: to be number one in share of stomach. At the time Hammer and Champy wrote, Taco Bell had been growing its sales by 22% annually and profits by 31%, making it a star contributor to Pepsico's excellent performance. Lately, however, Pepsico's excellence has faded, not only because of the heavy cavalry charge by Coca-Cola in soft drinks round the world, but because its restaurant earnings have slipped - with Taco Bell high among the culprits.

In its pursuit of low spenders, the chain has lost part of its overall franchise. Consequently, its share of the nation's stomach has been falling. Its fate highlights a besetting defect of re-engineering, which is that its projects tend to be finite, while markets are anything but. Visions, missions, targets and methods need constant revision and updating to reflect changed circumstances. And by the time the financial numbers reveal this necessity, it's too late to avoid deep trouble.

How can management look to the future in ways that everybody in the organisation can understand? The inventors of the balanced scorecard concluded that the basic model of management had broken down. It was suited to an era of mass production that has evidently passed. What management model works best in an age of differentiated tastes, products and services?

Framing a vision isn't even the first step. British Airways dreamt of being 'The best and most successful airline'. You'll hear others talk of being 'biggest and best', or 'the industry leader', or 'the preferred provider', or 'the best broad-based financial institution, a leader in our own chosen markets.' But these aims are too vague to serve as management's guidance. The balanced scorecard aims to cure this defect by making the vision specific: but even that's not enough - look only at Taco Bell. 'Number one in share of stomach' specifies a market share ambition. But what non-financial achievements will lead to the premier position?

STRATEGIC MEASURES
In the case of Chemical Bank, the question was answered by a matrix. Strategic objectives and strategic measures were worked out under four headings: (1) financial, (2) customer, (3) internal and (4) learning. Financial measures included return on investment, revenue growth, and the cost of servicing deposits. Customer success hinged on market share and retention. The internal measures embraced new product revenue, the cross-selling ratio, changes in the channel mix, the error rate, and the time taken to fulfill requests. Learning involved employee satisfaction and revenue per employee.

The logic behind these measurements is obvious and compelling. The revenue derived from new products is not only a test of the viability of those innovations, but of the vitality of the organisation. As the Mannheim professor Manfred Perlitz has pointed out, the required pace of innovation varies between industries and companies: if the product life-cycle is 20 years, you need only 5% of revenue to flow from novelties every year. If the cycle is a year (in PCs, it's now eight months), you must replace all your products annually.

You can both overdo and underdo the pace of innovation. Chemical Bank's industry of financial services has certainly overdone the rate of introducing 'products' (really services). In most cases, these offerings gave little new or valuable to the customers and were little different in nature or execution from the goodies of competitors. Most of them merely added to over-long rosters of under-managed items: typically, the National Westminster Bank once had 60 insurance products, of which a dozen contributed 90% of profits.

The revenue per product figures will winnow out the weaklings, however, while the overall total for new product revenue will show whether the company can pass the Perlitz test - compensating (and more) with new growth for the sales and profits lost by obsolescence.

The cross-sell ratio is of equal significance in financial services. Giving those services that trendy name of products diverted attention away from the foundation of these (and many other) businesses. Their true asset is the customer.

Retention of customers, and increases in revenues per customer obtained by selling additional services, are thus the keys to powerful organic growth. These companies, however, are notoriously indifferent to losing customers, and bad at selling them on from one service to another - partly because providers of different services (current bank accounts, say, as opposed to investments or insurance) are quite separate within the organisation. Moreover, databases may be wholly incompatible.

Nobody has worked out a truly effective solution to this knotty problem - in part because very few organisations have made successful cross-selling into a key measure of departmental and individual effectiveness. It's a non-financial measure which has direct financial benefits, provided that the cross-sold service is itself profitable - which the balanced scorecard should pick up. Among non-financials, the error rate and the request fulfilment time have obvious implications for cost, while also testing the effectiveness and responsiveness of the business at the most basic level.

ERRONEOUS THINKING
The long-term benefits of balancing Chemical Bank's scorecard will never be known now, because of its merger with Chase Manhattan. That's the key problem with the balanced scorecard. However well it has been worked out, and however well it aligns with current strategic thinking, the whole operation can be invalidated if that thinking is erroneous or the strategy changes. For alarming instance, Apple Computer used the balanced scorecard, while damaging itself (perhaps fatally) by errors that included refusing to license its operating software. Norton is unapologetic about this: the scorecard, he says, is concerned with strategic implementation, not strategy: the latter 'is not the issue - it's implementation.'

The trap here is that the company may end up performing beautifully what shouldn't really be attempted at all: Apple's products were mostly excellent, but not sufficiently superior to support a proprietary strategy in an age of open systems dominated by Microsoft. It's doubtful, too, that Apple's ambitions were widely shared. A very important non-financial indicator is the percentage of employees at all levels who understand the strategy. A high level of understanding doesn't of itself guarantee that the strategy has been properly worked out and endorsed: but a low level makes it absolutely certain that the strategy has been imposed from on high. Success must be less likely without true backing from the people who must make the strategy work.

Even if the balanced scorecard seems too cumbersome, its basic structural principles are surely essential and apply to any organisation. As so often in management, they flow in an unbroken virtuous circle, and have neither beginning nor end. However, you could choose to enter the circle by placing the customer first (which is an excellent idea in itself), and then going round the circle to answer this set of questions:

1. To achieve our vision, how should we appear to our customers?
2. To succeed financially, how should we appear to our owners?
3. To satisfy our owners and customers, what business processes must we excel at?
4. To achieve our vision, how will we sustain our ability to change and improve?

Each of the four questions has the same set of sub-questions: What are the relevant (a) objectives, (b) measures, (c) targets and (d) initiatives? It's an exercise from which any organisation, large or small, must benefit. It does demand concentration and hard thinking, but that's true of all good management. Quality of thought, however, is hard to include in a balanced scorecard, although its absence explains some of Renaissance's more startling research findings - that under 60% of managers in its survey didn't have a clear understanding of their company's strategy, which was (naturally enough) only implemented effectively in less than 30% of the cases.

The questions above force management to think about the key issues - and thought is the key to success. That's why the strength of a superb new management book starts with its title: Lean Thinking (Simon and Schuster). The authors, James P. Womack and Daniel Jones, are passionately opposed to muda, the Japanese word for waste. Continuous incremental improvement, or kaizen, will reduce waste: but there's a way to eliminate far more....

'Production activities for a specific product were rearranged in a day from departments and batches to continuous flow, with a doubling of productivity and a dramatic reduction in errors and scrap...Yet the great bulk of activities across the world are still conducted in departmentalised, batch-and-queue fashion fifty years after a dramatically superior way was discovered. Why?'

COUNTER-INTUITIVE
The authors say that 'flow thinking is counter-intuitive; it seems obvious to most people that work should be organised by departments in batches.' Then 'the calculations of the corporate accountant (who wants to keep expensive assets fully utilised) work powerfully against switching over to flow.' So the financial measures take precedence over the non-financial. If the 'dramatically superior way' were used, scrap rates and error rates and physical productivity would be emphasised, and the financial prowess of the firm would self-evidently improve.

The first awakening to this golden prospect may result in reengineering a whole process (like purchasing). But Womack and Jones argue powerfully for a far wider perspective: the entire 'flow of value-creating activities for specific products.' You start from specifying value: what does the customer really desire? Next, identify the value stream for each product or group of products, moving through the three critical tasks of (1) problem-solving (design, engineering, production) through (2) information management to (3) physical transformation (the progress from raw material to finished product in the hands of the user).

Identifying the stream 'almost always exposes enormous, indeed staggering amounts of muda.' You eliminate this waste by converting to flow. Next the customer 'pulls' the product from you, rather than being fed at your convenience. And, finally, another virtuous circle develops as the firm finds that 'there is no end to the process of reducing effort, time, space, cost and mistakes while offering a product which is ever more nearly what the customer wants.' Note that there's only one financial word in that sentence: cost. Enter this virtuous circle, though, together with that of the balanced scorecard, and you won't need to worry about the financials. They'll be marvellous.